Institutions’ Appetite for Alternatives Still Growing

September 26, 2014 (PLANSPONSOR.com) – A recent survey of investment consultants, conducted by Cerulli Associates, shows that they are actively increasing U.S. institutional investors’ level of exposure to alternative assets.

Institutions’ eagerness to adopt alternatives as part of their
overall investment strategy is rooted in their desire for greater
diversification, lower volatility and enhanced returns in a low interest-rate
environment, according to Cerulli. In addition, investors are looking to
alternative strategies to provide income, since deriving income from the traditional
asset classes has proven more difficult.

Cerulli says survey results also confirm that consultants
have generally expanded their clients’ allocations to hedge funds, private
equity and other private investments across both defined benefit (DB) and
nonprofit institutional investor types since year-end 2008. Going forward, investment
gatekeepers also anticipate increasing the proportion of alternative
investments used in institutions’ portfolios through 2015.

Another ongoing trend identified by Cerulli is investors’
interest in addressing more complex and volatile markets by abandoning the
traditional style-box approach to asset allocation. Instead, investors are
opting for a risk-based or objective-based methodology. As Cerulli researchers explain,
an objective-based framework allocates assets into categories according to the
role that they assume within the portfolio—for example, diversification or
return enhancer—as well as how they help to diversify specific portfolio
risks. As a result, many investors are abandoning their view of alternatives as
a separate asset class, Cerulli finds, and are classifying them according to the investment’s
desired objective or outcome.

This
reclassification typically leads to higher allocations to alternative assets
over time, researchers explain. Institutional investors on the nonprofit side
appear especially likely to receive guidance arguing for more alternatives,
Cerulli says, as about 50% of gatekeepers expect increased alternatives use for
endowments, and 33% expect increased use for foundations during the next one- to
two-year period. Conversely, fewer than one-fifth of these gatekeepers plan to
decrease their endowment and foundation clients’ exposures to alternatives.

Cerulli says DB pensions across plan types—corporate,
public, and Taft-Hartley—have increased their exposure to alternative assets
during the past five years to meet a diverse range of investment objectives.

Post-2008, most U.S. corporate DB plans were underfunded, which presented a
major challenge considering persistent low interest rates. Cerulli says DB plans often could not afford to concurrently derisk and earn the needed return to
fund future liabilities. As a result, these plans continued to allocate to
return-seeking assets, Cerulli says, such as hedge funds and private
investments, to enhance diversification and generate returns. Over the past
year, robust equity markets and rising interest rates decreased the gap between
pension assets and liabilities, and have resulted in improved funding levels
for many corporate DB plans.

On
the public side, Cerulli says DB pensions continue to struggle to achieve
actuarial returns between 7.5% and 8%. To meet these high target rates of
return, 40% of consultants plan to raise their public DB pension clients’ allocations
to hedge funds, and 47% anticipate increasing exposure to private equity and
venture capital over the next one- to two-year period, Cerulli finds.

Interestingly, Cerulli’s report also finds institutional investor exchange-traded fund (ETF) use is beginning to move beyond exposure to just equity and bond strategies
and into the world of alternative investments. Cerulli suggests investors, from
DB pension plans to defined contribution (DC) plan participants, see alternative
ETFs as a way to potentially enhance portfolio returns while also gaining
better intraday liquidity and transparency features compared with other forms
of alternatives.

Cerulli researchers suggest these facts, along with the point that alternative
strategies tend to be pricey from a fee perspective for certain product
structures (such as mutual funds), have drawn the attention of many seeking
inexpensive exposure to the alternatives asset class.

While commodities ETFs still dominate a large percentage of
alternative ETF assets, at about 58%, they have suffered as a result of the
gold sell-off in 2013, Cerulli says. Some of the largest commodities ETFs endured
substantial outflows in 2013, Cerulli finds, and 2014 has brought continued
volatile monthly flows year-to-date for commodities ETFs. Cerulli expects that as the U.S. dollar
continues to strengthen, growth in the commodity space will struggle, as the
U.S. dollar and commodities generally have an inverse relationship.

Cerulli says hedge fund firms are increasingly interested in
the use of inverse and leveraged inverse ETFs for their portfolios. Inverse
ETFs allow investors to bet against the market, as they are designed to
move in the opposite direction of their benchmarks. Investors can buy an
inverse ETF as a hedge if they are looking to make a bearish bet on the market
versus trying to outright short a stock or index position, which Cerulli says may pose
liquidity concerns or trigger other prohibitions, especially in the individual retirement
planning context.

Of the ETF providers surveyed by Cerulli, 43% stated that
the alternative ETF asset class was a primary focus of product development.

More
information on how to obtain a full copy of “The Cerulli Edge – U.S. Monthly
Product Trends” is available here.